Thursday, January 30, 2014

The General Theory, Chapter 19: Changes in Money-Wages

Chapter 19 of The General Theory is a crucial one: it discusses the consequences of nominal wages cuts in modern market economies.

Keynes begins by pointing out that neoclassical economics (which he called the “Classical” theory) assumes that a major reason why market economies are supposed to self-adjust is via flexible wages (and, by implication, prices). When wages are rigid, this is (allegedly) the cause of serious maladjustment in neoclassical theory (Keynes 1964 [1936]: 257).

Keynes accepted that a “reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes” (Keynes 1964 [1936]: 257), but there were many reasons why it would not generally do so.

Keynes also emphasised the need to distinguish the real wage from the nominal wage (or “money-wage”) (Keynes 1964 [1936]: 259).

Keynes analysed the effects of reductions in nominal wages in the following way:

(1) a reduction in nominal wages may reduce prices, but if the price falls are uneven, it will redistribute real income from wage-earners to other classes of society, such as producers and rentiers (the latter of whom often have fixed incomes) (Keynes 1964 [1936]: 262). But this is likely to reduce the aggregate level of consumption (or propensity to consume), so that the macroeconomic effects will actually be harmful (Keynes 1964 [1936]: 262).

(2) if the reduction in nominal wages affects industries that export products, then a reduction in money wages might stimulate demand for a nation’s exports and hence its domestic investment (Keynes 1964 [1936]: 262–263). Keynes noted that the UK of his day was an export-led economy (as compared with the United States), and that this accounted for the popularity of the belief that cutting money-wages would increase employment in Great Britain (Keynes 1964 [1936]: 263).

(3) but in an open economy, a reduction in money wages may increase the favourable balance of trade but worsen the terms of trade (Keynes 1964 [1936]: 263).

(4) If a reduction in money wages occurs but with expectations of further wage rises in the future, then this might be favourable to consumption and investment (Keynes 1964 [1936]: 263).

But, if a reduction in money wages leads to expectations of further wage cuts in the future, then it may well be counterproductive as it may lead to deferment of both investment and consumption (Keynes 1964 [1936]: 263).

(5) If both a reduction in wages and some fall in prices occur, and lead to a lower liquidity preference, then this will reduce the rate of interest, and prove favourable to investment.

But if, at the same time, there is an expectation of further wage and price increases in the future, then demand for long-term loans may not be as great as demand for short term loans (Keynes 1964 [1936]: 263), and if wage cuts cause loss of confidence and discontent, the increase in liquidity preference might more than offset the original reduction in the latter (Keynes 1964 [1936]: 264).

(6) A reduction of wages simply within one particular industry will be advantageous to the capitalist owners and/or managers of that industry, and a general reduction in wages throughout an economy might produce an optimistic mood amongst entrepreneurs in general, but labour troubles are likely to complicate matters badly:

“On the other hand, if the workers make the same mistake as their employers about the effects of a general reduction, labour troubles may offset this favourable factor; apart from which, since there is, as a rule, no means of securing a simultaneous and equal reduction of money-wages in all industries, it is in the interest of all workers to resist a reduction in their own particular case. In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.” (Keynes 1964 [1936]: 264).

“On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment. Moreover the effect of the lower price-level on the real burden of the National Debt and hence on taxation is likely to prove very adverse to business confidence.” (Keynes 1964 [1936]: 264).

To this Keynes could have added that private household debt will have much the same disastrous effects if wage and price deflation proceeds far enough.

Keynes, then, pointed to the negative distributional and other effects of wage reductions, and contended that only (4) or (5) gave much hope of inducing favourable results from nominal wage cuts.

But, with respect to (4), in order to prevent the expectation of further nominal wage cuts, a wage reduction would have to be deep and wide enough throughout an economy and limited to a single occurrence:

“The contingency, which is favourable to an increase in the marginal efficiency of capital, is that in which money-wages are believed to have touched bottom, so that further changes are expected to be in the upward direction. The most unfavourable contingency is that in which money-wages are slowly sagging downwards and each reduction in wages serves to diminish confidence in the prospective maintenance of wages. When we enter on a period of weakening effective demand, a sudden large reduction of money-wages to a level so low that no one believes in its indefinite continuance would be the event most favourable to a strengthening of effective demand. But this could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining.” (Keynes 1964 [1936]: 265).

Next Keynes notes that market equilibration in neoclassical theory depends on effective wage and price adjustment maintaining consumption and smoothing out changes in the demand to hold money:

“It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so. If the quantity of money is itself a function of the wage- and price-level, there is indeed, nothing to hope in this direction. But if the quantity of money is virtually fixed, it is evident that its quantity in terms of wage-units can be indefinitely increased by a sufficient reduction in money-wages; and that its quantity in proportion to incomes generally can be largely increased, the limit to this increase depending on the proportion of wage-cost to marginal prime cost and on the response of other elements of marginal prime cost to the falling wage-unit.” (Keynes 1964 [1936]: 266).

Keynes continues by noting that, in some respects, a cut in nominal wages is effectively equivalent to expansionary monetary policy (Keynes 1964 [1936]: 266; Hayes 2006: 178). But Keynes argues that the clear advantages of increasing the money supply over reductions in nominal wages make the latter an absurd policy.

Keynes sketches his argument for this view in the following way:

(1) It is paradoxically only in a fully socialist economy that wage policy can be done uniformly and effectively by administrative decree. In a market economy, it is unrealistic to think that there could be “uniform wage reductions for every class of labour” (Keynes 1964 [1936]: 267):

“The result [sc. uniform wage reductions] can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.” (Keynes 1964 [1936]: 267–268).

(2) Since certain classes of people such as rentiers have fixed incomes, a relatively rigid wage system is fairer:

“Thus the greatest practicable fairness will be maintained between labour and the factors whose remuneration is contractually fixed in terms of money, in particular the rentier class and persons with fixed salaries on the permanent establishment of a firm, an institution or the State. If important classes are to have their remuneration fixed in terms of money in any case, social justice and social expediency are best served if the remunerations of all factors are somewhat inflexible in terms of money. Having regard to the large groups of incomes which are comparatively inflexible in terms of money, it can only be an unjust person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter.” (Keynes 1964 [1936]: 268).

“The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (Keynes 1964 [1936]: 268).

(4) Finally, if a fall in interest rates is brought about by falling nominal wages, this can, as Keynes already noted, cause deferment of investment (Keynes 1964 [1936]: 269).

“In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges. There are advantages in some degree of flexibility in the wages of particular industries so as to expedite transfers from those which are relatively declining to those which are relatively expanding. But the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.

This policy will result in a fair degree of stability in the price-level; — greater stability, at least, than with a flexible wage policy. Apart from ‘administered’ or monopoly prices, the price-level will only change in the short period in response to the extent that changes in the volume of employment affect marginal prime costs; whilst in the long period they will only change in response to changes in the cost of production due to new technique and new or increased equipment.” (Keynes 1964 [1936]: 270–271).

As an aside, I note here how Keynes seems to have assumed that “administered or monopoly prices” were not very significant. And that leads me into my last point.

What is especially interesting about Keynes’s analysis is this: it concedes points to neoclassical economics – such as the idea of exogenous money, prices determined by marginal cost, and relatively flexible but uneven price movements – that Keynes did not need to concede, but still Keynes shows that the neoclassical theory is deficient.

BIBLIOGRAPHY
Hayes, Mark. 2006. The Economics of Keynes: A New Guide to The General Theory. Edward Elgar, Cheltenham.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

12 comments:

Chapter 19 is one of the most important in the General Theory. My Post-Keynesian professor, who otherwise taught ISLM analysis, had the whole class read and comment on this chapter in great detail. Here are my notes if you're interested:____________________

 There are a number of reasons that Keynes gives why a decrease in money wages will not necessarily increase employment. Below we outline the most important in order of their relative importance (with 1 being most important etc.):

1. If wages falls the marginal propensity to consume will also fall. Even if prices adjust downwards, workers will save more relative to their income. If investment is not increased to make up the gap – and there is no reason to assume that it will – aggregate demand will fall by the same amount.2. As wages and prices fall, total real indebtedness rises. This may result in bankruptcies and otherwise put strains on companies’ balance-sheets.3. Expectations are important and if wages/prices are expected to fall further entrepreneurs will postpone investing in new capital goods.4. Likewise, price instability will make it very difficult for entrepreneurs to make business calculations going forward which may induce them to invest less.5. If wages and prices fall, those in society with more savings – i.e. the wealthier members of society – will hold more of the wealth. Since these people probably have a lower propensity to consume, total aggregate demand will likely fall.

 While Keynes also notes some offsetting features, all of the above are likely to have adverse effects on aggregate demand and, hence, adverse effects on employment. Keynes is implicitly looking at these problems in real or historical time rather than in the stationary terms of the ISLM model. Thus he includes and emphasises the effects of expectations and responses to perceived losses of wealth. While these are included in the ISLM model to some extent, they are often veneered over.______________

If I rewrote that today I would put number 5 in the place where number 2 would be. Indeed, read properly the debt deflation factor is just a redistrbution because even though aggregate debt repayments increase, aggregate interest income increases. I.e. the money doesn't disappear, what occurs is a redistribution from debtors to creditors (the opposite occurs in an inflation).

My closing point, however, is I think the most important. In this chapter Keynes is, as you said, conceding all the points to the mainstreamers (he later rejects flex-price models, I think, in 1938) but he is not doing equilibrium analysis. He introduces expectations and with them historical time.

Now, the two main redistributionary points (5 & 2) will still work if you use an equilibrium model but I don't think that point 1 will unless you assume that workers save and consume based on nominal rather than real wages. BUT I think the most interesting aspect of this chapter is that Keynes is analysing the economy in real or historical time. And when you do that you see the economy as the messy system it is. This is the reason, I think, why he basically advocates a fixed-wage policy -- which, by the way, finally found expression in the Job Guarantee programs of Minsky and the MMTers.

"decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage unit unchanged has the opposite effect."

and

"In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges."

One could make a good case that Keynes was the father of Market Monetarism. (see: http://uneasymoney.com/2011/12/09/ngdp-targeting-v-nominal-wage-targeting/).

Except that the money supply is endogenous, money supply growth largely driven by demand for credit (which collapses during recessions), and monetary policy is likely to be highly ineffective in times of depressed expectations, so that fiscal policy is needed to increase the money supply, not just monetary policy.

These things, I think, are the crucial parts of Keynes' system you miss, and some of them he came to accept only after the GT was published.

Possibly: the first quote seems inconsistent with endogenous money theory as described by Post-Keynesian..

On "the money supply is endogenous, money supply growth largely driven by demand for credit (which collapses during recessions)," There will indeed be a very pro-cyclical element to the demand for credit and in extreme cases the demand for credit may "collapse" . This does not mean that monetary policy cannot be used to counteract those tendencies by adjusting the size of the monetary base in order to hit a nominal target (like the nominal wage level).

Basically, if you trawl through the GT, you can find passages that presage ambiguity aversion, Market Monetarism, critique of Philips curve, behavioral economics, secular stagnation!

But Keynes would have been highly dubious about using monetary policy to target money wages. I am not sure now, but my impression in reading Keynes was not for fiddling with monetary policy. You can try to target stable employment and with fiscal policy, although market monetarists will have nothing to do with it!

“In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges."

This bit suggests that Keynes would not recommend a "stable general level of money-wages" under a fixed exchange rate system. But at the same time didn't Keynes advocate a fixed (or pegged) exchange rate system, rather than a floating exchange rate system?